Section 453 Deferred Sales Trust: Simplified and Explained
Carl E. Sera, CMT
April 11, 2023
Section 453 Deferred Sales Trust is a tax strategy real estate owners use to defer tax payments and maximize their capital gains. You can learn more about how it works and its benefits for investors.
If you are considering selling a business, corporation, or investment real estate, you may have to pay capital gains taxes. And if you don’t want to continue holding an investment property, a Deferred Sales Trust could be your best bet.
According to Section 453 of the Internal Revenue Code, the Deferred Sales Trust is a financial structure that provides investors with a solution that allows them to defer capital gains on the sale of their assets and redirect the sale proceeds into cash or whichever types of qualified deferral investments best suit their needs, income requirements, and objectives.
What is a Deferred Sales Trust?
A (DST) Deferred Sales Trust is a legal agreement between an investor and a third-party trust in which the investor sells real estate to the trust in exchange for specified future payments, known as installments or installment sale notes, over an agreed-upon time period. Investors can defer capital gains taxes over time using a Deferred Sales Trust as part of their investment strategy.
What Types of Assets Can be Put into a Deferred Sales Trust?
A deferred sales trust is a legal structure that allows for the deferral of capital gains taxes on the sale of assets. It is a flexible tool that can be used to defer taxes on a wide variety of assets.
Some of the most common assets that can be put into a deferred sales trust include real estate, businesses, and securities such as stocks, bonds, and mutual funds. However, it is important to note that the types of assets that can be placed into a deferred sales trust are not limited to these categories.
Other assets that may be eligible for placement in a deferred sales trust include artwork, collectibles, intellectual property, and even certain types of personal property. The critical factor in determining whether an asset is eligible for placement in a deferred sales trust is whether it is considered a capital asset for tax purposes.
It is also worth noting that there are certain restrictions on the types of assets that can be placed in a deferred sales trust. For example, if the asset in question is subject to a mortgage or other secured debt, it may not be eligible for placement in a deferred sales trust unless certain conditions are met.
In addition to the types of assets that can be placed in a deferred sales trust, it is essential to consider this tool's potential benefits and drawbacks. While a deferred sales trust can offer significant tax benefits, it may also involve complex legal and financial considerations that should be carefully evaluated before making a decision.
How Does a Deferred Sales Trust Work?
Deferred sales trusts begin with the owner transferring a property or other asset to a business trust, which is subsequently kept by a third party (trustee) on their behalf. The trustee then sells the asset, completes the transaction, and agrees to pay the original seller in installments.
The asset value is calculated before it is placed in the trust, and the sale occurs immediately, so there is no growth in value, and the trust does not owe capital gains on the sale. No capital gains tax would be due because the seller received no money in the initial transaction.
The seller would only have to pay capital gains tax if the trust made an installment payment after the transaction.
Determining the Taxes in a Deferred Sales Trust
The IRS has a simple formula for calculating how much of the realized gain is owed when the installment payments are distributed:
Gross Profit Ratio = gross profit divided by the sale price
For example, suppose someone purchased a property for $200,000 and sold it when its value climbed to $1,000,000. The gross profit in this instance would be $800,000, and since it sold for $1,000,000, the gross profit ratio would be.80.
Assume the installment agreement specifies that a $100,000 lump sum payment will be given annually. The original seller would only owe capital gains on $80,000 of the $100,000 they get each year because the gross profit ratio was .80, and the tax rate would vary depending on their particular status.
Thus far, we can see that utilizing a Deferred Sales Trust arrangement to defer capital gains can allow you to break up the time frame in which you must pay taxes on your capital gains, spreading your tax burden over several years rather than having to pay it all in one lump sum.
Pros of a Deferred Sales Trust
- One potential advantage of using an installment sale rather than a 1031 exchange to defer capital gains taxes is that installment sales are not subject to the stringent requirements of 1031 exchanges. In particular, under the Tax Cuts and Jobs Act of 2017, 1031 exchanges are limited to real estate. In contrast, DSTs and other installment sale agreements can be utilized to defer capital gains on any asset.
- The sale revenues are managed within the trust as any other investment portfolio. This can provide flexibility in income stream management, tax efficiency, and proper portfolio diversification. When an investor sells a property after previously executing a 1031 exchange, a DST can also provide a tax-efficient exit option.
- Utilizing deferred sales trust as a strategy allows you to get payments only when needed. You can choose to receive the earned interest or set up the principal payment however you choose. This option is best suited for retirement income or cash flow from the sale of a real estate asset.
Cons of a Deferred Sales Trust
- The IRS, on the other hand, has provided little to no guidance on how to defer taxes through an installment sale. The primary reason for not receiving capital gain is that you do not earn immediately from the transaction performed with a DST. Considering this rationale, specific constraints exist on how a Deferred Sales Trust must be structured to avoid capital gains taxes.
How is Income Generated from a Deferred Sales Trust?
A deferred sales trust is a legal tool that allows the seller of an asset to defer paying taxes on capital gains from the sale. The seller transfers the asset to a trust, with the trust acting as the seller and receiving the proceeds from the sale. The trust can then use the proceeds to invest in various assets, such as stocks, bonds, mutual funds, ETFs, interval funds, annuities, and real estate.
The income generated from a deferred sales trust is derived from the earnings and appreciation of the trust's assets. For example, if the trust invests in stocks that pay dividends, the trust will receive those dividends as income. If the trust invests in real estate, the income can come from rental income or capital gains from the sale of the property.
The income generated from the deferred sales trust is distributed to the beneficiaries of the trust, who are typically the seller and their family members. The income can be distributed over a period of time, such as monthly or annually, or it can be reinvested for further growth.
It's important to note that the income generated from a deferred sales trust is subject to taxes. However, since the income is distributed over a more extended period, the tax liability may be lower than if the seller received the total sale proceeds in a single year.
In summary, income from a deferred sales trust is generated from the investments made by the trust. The income is distributed to the beneficiaries over a period of time and is subject to taxes.
If you're like most people, finding a means to reduce your tax bill, especially on highly appreciated assets, is worth discussing. Setting up and managing a deferred sales trust might be challenging, but it can provide distinct tax advantages that other solutions cannot.
Furthermore, as with other trust-related strategies, it's best to consult with a tax specialist or financial advisor before implementing to ensure the rules are followed and you receive the most value from the transaction.
Sera Capital is a wealth management consulting firm specializing in all aspects and all available tax-efficient exit options for business owners, real estate investors, and developers. Our team works with you and your advisors to examine all available solutions, including 1031 Exchanges, Delaware Statutory Trusts, 721 UPREITS, Opportunity Zone Funds, and Section 453 Installment Sales, including Deferred Sales Trusts and Structured Installment Sales. We have two mottos. The first is “We help landlords and business owners exit tax efficiently,” and our second is “When you want out, call us in.”
If you want to explore your options, make a no-obligation appointment with us today. Discover the possibilities.
Contact Sera Capital to schedule an appointment to learn more about deferred sales trusts and see if it is a smart wealth strategy for you.